Is 'Smart' Smart? No, Simplicity And Sensitivity Are Smart

Summary

The Nobel Prize in Economics has been awarded to two contract theorists.

Not surprising, since the economics of contracts has assumed new importance following the Financial Crisis.

The article considers two key financial contracts and their quality.

The objective is to find contract improvements that will help restore big bank profitability.

You got to keep it simple these days and that's just that.

-- Van Morrison

The Nobel Prize for Economics was awarded this week, to Bengt Holmström and Oliver Hart, for their insights into the economics of contracts. By this decision of the Nobel Committee, we understand that the economics of contracts is important. But all contracts are not created equal. There are good contacts - that encourage the economic objectives of the contract's parties, without interfering substantially with the welfare of others - and bad contracts, that fail to meet these two objectives. Contracts and their good and bad effects are constantly in the news, particularly lately. Perhaps this ubiquity influenced the decision of the Nobel Committee - which apparently came as a surprise to both recipients of the Prize. This article begins a process of examining the quality of key financial contracts that affect the fortunes of investors and the companies in which they invest.

It is no exaggeration to say that the biggest change in the business of transactions since 1970 has been movement of trading activities from purchase and sale of assets, to the entry and exit of contracts with no initial asset value - especially contingent claims. Most of these contingent claims fit the definition of a derivatives trade. Thus contracts and their quality are front and center when asking why our financial institutions have been performing so poorly. Is it wise to enter contracts instead of exchanging assets? The answer is not the obvious "yes" that it seemed to be before the Financial Crisis.

Conditional contracts are otherwise known as "smart" contracts. I am an advocate of simplicity in financial matters. Smart is only smart when it's also simple - or so say Albert Einstein and Isaac Newton. This article considers "smart contracts," very popular with bank derivatives and other traders, most of whom were hired at high salaries due to their Universities' opinion that they were smart.

A "smart contract" has come to mean that the contract's terms imply payment based on the value of some unknown, changing, environmental variable, such as an interest rate or the dollar price of a foreign currency. A derivatives contract is a kind of smart contract where the interest rate or price that generates a payment from one party to another determines the value of some "underlying" security or commodity.

The relative quality of two derivatives contracts. Compare, for example, the two most important derivatives contracts, measured by volume of trade - Eurodollar (E$) futures and interest rate swaps ((NYSE:IRS)). Understanding the economic incentives embedded in these derivatives contracts - their function and malfunction - are one key to the forecasting the success of the companies whose performance I examine most frequently: the exchange management firms, CME Group (NASDAQ:CME), the Intercontinental Exchange, Inc. (NYSE:ICE), The London Stock Exchange subsidiary, LCH:Clearnet (LON:LSE), Investors Exchange, (NYSE:IEX), TradeWind Markets, Nasdaq (NASDAQ:NDAQ), and BATS (:BATSBATS); and the large dealer banks, Bank of America (NYSE:BAC), Barclays (NYSE, BCS), Citigroup (NYSE:C), Deutsche Bank (NYSE:DB), Goldman Sachs (NYSE:GS), and JP Morgan Chase (NYSE:JPM).

But a smart contract, in finance, is stupid when it fails to meet both parties' basic objectives. Or when "smart" seeks to "outsmart" other claimants, or worse - the public. In analysis of the economic quality of contracts, two characteristics are paramount:

Meets both party's objectives. A good contract meets the original objectives of both parties to the deal, regardless of the outcome. For example, a derivatives agreement will inevitably require one party to make a payment to the other that she had hoped she would not be expected to make. If the contract was well considered, however, her overall objective will not be compromised by the payment.

Has no important effect on third parties. OTC derivatives, credit default swaps (CDS) especially, are sometimes accused of creating systemic risks, such as "daisy chains" of fails, where a single bankruptcy results in a series for bankruptcies as the original failure to pay forces the next counterparty to fail on its commitments. If this assessment is fair, then a CDS is an example of a bad contract.

The article first describes a contract type that put simple before "smart"- the first successful derivatives, financial futures; E$ futures in particular. It then describes how derivatives traders, making a transition from exchange-traded E$ futures to OTC IRS swaps, lost themselves in complexity; how the derivatives dealing community attempted to bail themselves out of the unintended effects of this complexity at the expense of others; and failed. The article concludes by separating OTC derivatives into two piles - then asking what is simple and smart for each pile.

If simplicity were restored to the derivatives markets, systemic risk would be dramatically reduced. Then perhaps market regulators could be persuaded to release the banks from the draconian regulatory costs of trading these instruments; and dealer profitability restored. This might result in the recovery of the sick men of banking - dealers like Bank of America, Barclays, Citigroup, Deutsche Bank, Goldman Sachs, and JP Morgan Chase.

E$ futures. First, by way of contrast, the quintessential contract that is smart because it is simple: E$ futures. One key property of futures contracts - any layman can read and understand them. This is by design. Particularly the contracts of the old Chicago Mercantile Exchange, a predecessor of CME Group. CME futures were written by economists, not lawyers, for two reasons.

The Exchange wanted to avoid unnecessary legal language so that lay users could understand them.

The Exchange wanted to be as certain as possible that the economic incentives of users would lead to high volume, along with low risks and other costs of trading.

Before E$ futures contracts were introduced in the early '80s, the CME already took pride in the simplicity of their existing futures contracts, in direct contrast to the always-more-complicated Chicago Board of Trade (CBOT) futures contracts. It was the "secret weapon" by which the CME intended to surpass the CBOT, then number one in futures trading.

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But E$ futures, although simple, and for that reason highly successful, were not the hoped-for solution to the central problem of finance in the 1980's - the management of financial institutions' out-of-control interest rate and price risks. The reason, once again, was complication. Simple things can create complicated situations. Thus it was with E$ futures.

The basic financial problem E$ futures were designed to manage was the enormous increase in interest rate risk faced by financial institutions following the advent of Eurodollar trading in London, risk that was a result of the higher, more volatile, interest rates of the fourth quarter of the 20th Century. E$ futures were perfect for traders in the London dollar deposit market; but a failure in the management of interest risk in the more important lending business of the banks.

Over-the-counter (OTC) Interest rate swaps. Futures are marked to market; loan income is deferred. As a result, a futures hedge of the interest rate risk of a loan produces net income figures that resemble scrambled eggs. This problem was resolved by the introduction of the OTC interest rate swap, the first OTC derivatives contract. Swaps, because they are accounted for on a deferral basis, like the loans they hedge, were the antidote for the confusing financial statements of the lending world's futures hedgers.

The signature contract of the OTC derivatives market is "The International Swap Dealers Association (ISDA) Master Agreement." This, like the E$ contract, was written with an intent to simplify matters. The ISDA agreement is the uber-agreement that served as the derivatives dealing community's attempt to gain the risk benefits and simplicity of futures, without losing the accounting provisions of swaps.

The ISDA agreement is the combination of two ideas - one good, one bad.

The good idea behind ISDA agreements is to regularize swap agreements - making them as close as possible to identical from one trade to another - reducing the incidence of one problem that users of these complex deals were facing, not understanding the deal they had made. The ISDA Master Agreement simplified the interest rate swap market, making the market more liquid, enabling it to assume its significant role in interest rate risk management.

The bad idea was the plan behind the ISDA push to make the Master Agreement universal. Once all derivatives market participants were signers, the ISDA Master Agreement became the derivatives industry's stalking horse in moving Congress to release derivatives dealers from the "stay in bankruptcy," the essential judicial protection of the creditors of derivatives dealers' counterparties in bankruptcy - preventing dealer seizure of counterparty assets without third party approval. With derivatives' exemption from the stay, derivatives dealers can front-run other claimants, placing all derivatives obligations above the reach of the judiciary.

It was the hope of the ISDA that, when a counterparty defaulted, the ISDA - rather than the judiciary - could deal with the counterparty's obligations, within a few days. The idea was to prevent daisy-chains. That is, no big failure from one party to another; that forces a failure to a third party; a fourth; and so on - the essential systemic risk imagined by the Chicken Littles of derivatives analysis.

The major error in this plan to provide an advantage to derivatives in bankruptcy is that it intentionally left all other claimants upon the estate of a bankrupt party in a subordinate position when the estate's assets are divided. Certainly no ordinary creditor would approve of this decision. Congress understood that it was playing favorites with the publicly unpopular derivatives dealers, evident by the methods it used to change the bankruptcy code - discussed in my article, " Inside 'Bankruptcy For Banks' - Dr. Dodd Frank And Mr. Appropriations Bill." Congress hid its changes in the bankruptcy code within other bills passed for other reasons - most popular was the necessary annual Congressional Appropriations Bill.

How to fix OTC derivatives agreements. The key to understanding how to make derivatives systemically safe: When is it appropriate for derivatives settlement to stay out of court, and when is it not? That question was unintentionally answered by events in the Lehman Brothers bankruptcy. There were two levels at which derivatives obligations' ISDA Master Agreement failed during the Lehman bankruptcy.

Derivatives between dealers were settled within the CME and the interest rate swaps clearing house, LCH:Clearnet, within a week, but at terms of dubious fairness to the Lehman estate. But without recourse to the ISDA Master Agreement.

Bilateral derivatives were a catastrophe. Not because of the systemic risks and "daisy chains" threatened by the ISDA; but because there was no governmental or judicial plan to resolve the many different claims involved. The ISDA Agreement failed to function. The bankruptcy courts were inevitably involved, but provided little relief to the Lehman estate. The courts dithered, mostly because of inadequate legal and case law guidance for appropriate resolution. By trying to keep OTC derivatives out of bankruptcy court, the law gave no guidance once bankruptcy court was the only available avenue to resolution.

The clear path to solving the potential systemic problems created by OTC derivatives is to divide them into two piles. In the first pile is dealer-to-dealer OTC derivatives; the second, dealer-to-customer OTC derivatives.

The first pile can be kept out of court with a few changes to current practices. The cleared dealer-to-dealer swaps were kept out of court in the Lehman bankruptcy. However, the Lehman estate's bleeding from the clearing house settlements was substantial and unnecessary. The following changes would reduce the problem.

Require the dealers to use LCH:Clearnet's daily settlement price on their books, rather than a price of their own invention.

This would eliminate the need for an auction process in default, since there would be no legitimate disagreement on value. There would be no ugly clearing house auctions, like those that adversely affected Lehman's other creditors.

The second pile, bilateral derivatives, is more problematic by orders of magnitude. The variations among customer derivatives trades are greater than those between dealers, since customers have no concern for liquidity of a transaction they don't plan to reverse.

The idea that ISDA contracts, or any contract, are a replacement for the bankruptcy code, is a failed notion in resolving bilateral OTC derivatives. There is no such cheap remedy. But since bilateral swap agreements are not linked in daisy chains like dealer-to-dealer swaps, and since the counterparties of bilateral swaps are more numerous by far than the parties to inter-dealer swaps, bankrupt counterparties to bilateral trades are both more common and less dangerous than dealer-to-dealer swaps bankruptcies. There might be some sense in establishing judiciary specialists in resolution of bankruptcies involving bilateral derivatives exposure.

In short, if the dealers were required to make their common trades uniformly constructed and priced, they would not use Congress' exemption from the stay in bankruptcy. And bilateral derivatives, both relatively common and systemic-risk-free, should not use the stay. These changes, including getting rid of the dealer-biased exemption from the stay in bankruptcy, would put the quality of the OTC derivatives contracts on par with the quality of futures contracts.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.